Post-lockdown the economy will need a different kind of stimulus
The role of monetary and fiscal policy during lockdown was to sustain household and corporate cashflows in the face of an intentional freezing of economic activity. The objective was to prevent defaults, sharp contractions in household cashflow, and preserve the capital stock so activity could resume post-lockdown.
It is now highly unlikely that there will be a rapid return to full capacity. A recovery to capacity utilisation rates of 85% to 95% of prior activity looks likely on a six to 12 month view. This would still amount to a significant level of economic contraction and would be consistent with a rising unemployment rate. To mitigate these effects we need further, substantial, fiscal and monetary stimulus.
The risk of a fiscal error is very high
There is no evidence of a significant constraint on government borrowing outside the Eurozone’s periphery, given the collapse in bond yields. There is no reason to expect this to change for at least several years. Despite widespread fears of supply-side driven inflation, it is already clear that deflation is a greater risk. We entered this crisis with stubbornly low inflation rates, and crises of this kind accelerate pre-existing trends. Expect lower inflation rates and consequently interest rates stuck at near-zero for the foreseeable future. Outside of the Eurozone, bond yields are predominately a function of prevailing levels of short-term interest rates. Governments will be able to fund themselves at close to zero.
Despite these logical arguments it is likely that the fiscal authorities will panic themselves into under-stimulating over the next twelve to 18-months. One of the unique features of the Covid recession is that the fiscal authorities reacted relatively rapidly and at huge scale. This was a consequence of the fact that the recession was self-induced and so did not take us by surprise. Additionally, there was no one to blame. Unfortunately this also suggests that sustained stimulus will be hard to stomach in the face of eye-watering deficits, despite the absence of a near-term budget constraint.
A proposed innovation in dual interest rate policy
For this reason, there is a high likelihood that monetary policy will have to compensate. Conventional wisdom is that with interest rates already so low monetary policy can’t really do anything other than stabilise asset prices, and perhaps support fiscal policy. There has more recently been an attempt by central banks to target lending at preferential rates, either directly, or through banks, to the private sector, but significant further innovation is required.
The most significant innovation in monetary policy over the past few years, which remains significantly unnoticed, is what I call ‘dual interest rates’. The idea is very simple: when interest rates get close to zero the central bank needs to separately target the interest rate on loans and the interest rate on deposits. If interest rates on loans decline and interest rates on deposits rise the cashflow of both savers and borrowers rises which is an unambiguous stimulus.
How does this work in practice? It is clear at the moment that the economy would be substantially supported if for example all mortgages were priced at -2%. So instead of paying interest, all households with mortgages would be receive a payment of 2% of their outstanding mortgage. Similarly, it would make sense if SME loans were paying zero interest.
So far, dual interest rates as introduced by the ECB, have been aimed at encouraging new lending funded at interest rates below the interest rate banks receive on reserves. The innovation I am suggesting is that funding should be provided to banks at steeply negative interest rates subject to them repricing their existing loan books. So stimulus is not contingent on loans growth. Similarly, there should be an innovation with tiered reserves: the interest rate on required reserves should be raised on the requirement that banks pass some of the increase in net interest margins on to depositors.
Central banks need to start by targeting the interest rate borrowers will pay. For example, the Bank of England or ECB could lend to banks at an interest rate of -3% or -4% for 18 months, contingent on the banks repricing mortgages at -1% and SME loans at 0%. The central bank should simultaneously raise the interest rate on bank deposits held at the central bank, which are growing rapidly due to QE, and require that these rates be passed on to savers.
Infrastructure for perpetual loans to households
We are now entering the phase of economic recovery, and a large persistent shortfall in demand looks highly likely. We will need persistent stimulus. Central banks should launch a programme of perpetual zero interest loans for all adult citizens. Implementation in the UK could be administered by the four largest banks. Citizens who currently bank with those four banks would automatically receive the payment in their bank account. Those who bank with other banks would make an online application, and those with no bank account would be eligible to apply online for a pre-paid debit card. A similar model should be put in place in the Eurozone, executed by national central banks under the direction of the ECB. The European Parliament should declare its support for the programme to address issues of legitimacy.
In the UK, the Governor of the Bank of England should request approval from the Chancellor for the perpetual loan scheme, because although it is clearly within the remit of monetary policy – and the Bank has operational independence – the distributional consequences are more transparent than usual with monetary policy, albeit much ‘fairer’.
The strength of a perpetual loan scheme compared to other forms of policy support – for example fiscal policy – is that the Bank of England can adjust and accelerate it literally at the press of a button – and it impacts the economy instantaneously. Furthermore it protects us against premature austerity, which is likely.
Obviously, these policies are not complete – not everyone would benefit, and some will benefit who don’t need to. That is true of all policies, and is not a reason not to act. It is a reason for supplementing these monetary policies with targeted fiscal policies and using the tax system to support distributional equity.
Having said that, approximately 98% of the population have bank accounts, so perpetual loans would probably have more complete coverage than any other policy.
What is important is that we are threatening huge self-harm through extremely high unemployment, widespread business failure, and enormous financial stress across the household sector. We have the means to tackle this, with minimal bureaucracy. These policies should be implemented urgently.